Category Archives: Balance of Payments

John Plender: today’s US = post-WWI UK

June 22, 2010 By in Balance of Payments, Current Market Thoughts, Strategy Tags: , , , , , , , , , , , , Leave a comment

As regular readers of Practical Stock Investing will have gathered, my favorite financial newspaper is the Financial Times (the New York Times would be a distant second).  I don’t know the FT columnist John Plender well enough to say I’m a fan, but he has written a very interesting recent column about how the structural government deficit problem in the US is playing out.  Here’s my paraphrase (with some additions of my own):

One of the most striking features of the US for any investor, especially one with experience in developing markets, is that the government is able to borrow large amounts of money at reasonable rates of interest.  During the past ten years, the country has swung from a government budget surplus to a deep deficit.  The bulk of the spending seems to be supporting consumption rather than investment–thereby generating no economic return in future years that might go toward servicing the debt.  The US depends heavily on foreigners, particularly in recent years on China, for financing–that is, sources that are arguably less committed than citizens to fund the country.  Finally, Washington seems oblivious either to the need to formulate any plans either to restore itself to fiscal balance or to the possibility that it might one day reach the limit of its metaphorical credit line.

The situation in the US is far different from that of a developing country.  For one thing, it’s a large industrialized country with lots of accumulated wealth.  For another–and this is doubtless much more important–the US dollar is the world’s de facto reserve currency.  In other words, the US runs the bank, so it’s much easier for it than for any other country to get a new loan.

Two years or so ago, it was beginning to look pretty grim for the US.  It seemed the country was fast coming to the end of its credit line.  A Wall Street-Washington alliance of political favors and campaign contributions, complete with a regulatory apparatus that looked the other way, led to rampant speculation and the near destruction of the banking system–requiring a mammoth increase in government debt to fund a rescue.   An alarmed China, a very large creditor, began to look for places to unload its very large dollar holdings–mostly by buying physical assets or lending funds to other developing nations–trying to reduce its exposure to assets it felt sure would depreciate in value.  Washington, of course, seemed unwilling/unable to grasp what was transpiring.

Then a new political party came into power in Greece and announced the former government had been falsifying that country’s national accounts for years.  As we all know, the euro imploded as a result.

Ironically, in the short term this has been a good outcome for the US and Europe. 

To Mr. Plender’s eyes, the US situation today resembles that of the UK between the two world wars.  As still the center of the global financial system, Britain’s government debt instruments continued to have safe haven status, even though that country had become a shadow of its former robust economic self.

I don’t know enough about economic history to judge how exact the parallels are.  But the main Plender point is that the collapse of the euro has perversely alleviated near-term economic pressures for all parties.  The entire EU has devalued, not just Greece.  That fact may not alter the relatively poor situation of Athens vis-a-vis the rest of Europe, but it does mean that the EU as a whole has gotten an economic shot in the arm. 

At first blush, this seems to be an unequivocal negative for the US.   But the collapse of the euro has knocked out the only credible rival for the US dollar as a safe haven currency for the globe.  By default, then, despite the fact that the US is no longer a pristine credit, the rest of the world is continuing to lend to it as if it were. 

This period, which may last for a number of years, is not a pardon.  It’s more like a stay of execution, or a grace period in which the US has the opportunity to get its fiscal house in order without suffering any severe financial consequences.  At the same time, there’s the risk that a profligate Washington will run up an even bigger tab–causing that much more future pain–before the bill becomes due.  As Mr. Plender puts it:

“In such circumstances the question is not whether the dollar will retain its haven status, because it will, but how much damage will be done as global investors offer US policymakers the rope with which to hang themselves. That is the long and the short of it.”

Martin Wolf: the ants and the grasshoppers

May 28, 2010 By in Asian economic development, Balance of Payments, China, currency effects, economics, Hong Kong, Japanese development, reserve currency, Strategy Tags: , , , , , , , , , Leave a comment

Martin Wolf, one of my favorite economic commentators, recently wrote an update of the fable of the ant and the grasshopper (actually a cicada, but…) in the Financial Times.

Aesop

In the original story, attributed to Aesop, the ant works all summer to store up food for the winter while the grasshopper plays.  When the weather turns bad, the grasshopper asks the ant for aid.  He is rebuked for his idleness and left to die.

Wolf

In the Wolf version, there are industrious “ant” countries (China, Germany and Japan), which produce goods and export them to lazy “grasshopper” countries (like the US, UK and the PIGS) who dabble in activities like real estate, which by and large generate no economic return.  (that is:  if you build a factory, you can make stuff in it that you can sell at a profit.  If you build a beach house, it just sits there.  It’s like buying a very expensive home entertainment system.)

The grasshoppers get the money to do this by borrowing from the ants’ banks, using their real estate as collateral.

At some point, the ants figure out what’s going on and realize they’ve made a very bad deal.  The grasshoppers are never going to repay and the collateral is not particularly useful.  On occasion, the grasshopper economies weaken as real estate prices wobble and then fall.  Does the grasshopper government learn the folly of its ways?  No.  It simply lowers interest rates and borrows more from the ants to pump up the real estate market and keep the party going a while longer.

The ants help out because they don’t want to admit that they’ve made all these horrible loans.  So they end up throwing good money after bad.

In the Wolf fable, there are two sets of ants/grasshoppers:  Germany/rest of the EU, and China/EU + US.

me

I think the grasshopper/ant metaphor is a very useful way of framing the structural problems that the US and Europe face today.  In particular, it highlights the fact the Europe is in double trouble:  it’s China’s largest trading partner, and the EU faces the internal Germany/Greece dilemma as well.

I think the story needs a couple of nuances to make it a better reflection of today’s global economic situation, though.  For instance:

a post-WWII phenomenon

The first “grasshopper” was the US and the first “ants” were Japan and Europe.   The original relationship benefitted the US, of course, but it was also essential in enabling the rest of the developed world to rebuild after the destruction of their industrial infrastructure during WWII.  Two of todays ants were the initiators of this devastation.

After the fall of the Berlin Wall and the reunion of the two Germanys, that country faced enormous economic difficulties:  the west’s outdated plant and high-cost labor, the pitiful state of the east after almost a half-century of Soviet rule, and the consequences of the inflated exchange rate at which the merger was done.  So Germany really needed grasshopper counterparts to alleviate what would otherwise have been a decade of even greater misery.

not just good and evil

There’s a wider point.  Like the sadist and the masochist (maybe not the best analogy, but the only one I can come up with at the moment), the relationship may not be healthy but both sides do get something out of it.  The ants get technology transfer and the opportunity to radically raise their standard of living.  The grasshoppers get a chance to invest directly in the fast-growing ant economy.  They also get cheaper foreign-made goods.

China is a very unusual ant

For one thing, it’s much larger than any of the others.

It also doesn’t have the hangups of its fellow ants:  Germany’s commitment to make the one-Europe project work, and Japan’s history of extreme deference to the wishes of the US as a result of having lost WWII.

China gets what’s going on.

To me, it gives every indication that it thinks it has gotten all the value it can out of the grasshopper/ant dynamic and is determined to move on.  It has already started to convert its dollar foreign currency reserves into physical assets through foreign acquisitions by state-controlled companies.  Unlike Japan, which has never wanted the yen to be a world currency, China is taking steps to make the renminbi a vehicle of exchange among emerging countries.  It is also trying to grow its way out of its grasshopper problem by strengthening economic ties with other emerging nations.  China won’t thereby reduce the size of its problem of being a creditor to grasshoppers, but it may be able to reduce the significance of these liabilities if it can expand its trade in a healthier way with non-grasshopper nations.

The mess in Greece–any silver linings?

May 2, 2010 By in Balance of Payments, economics, emerging markets, government debt trap, reserve currency Tags: , , , , 2 Comments

the mess

When Greece was admitted into the EU about a decade ago, there were suspicions that the country had fudged its economic numbers a bit to meet the minimum criteria for entry. But the EU chose to look the other way.  In the middle of the decade, more evidence of cheating was uncovered, but again the EU chose to look the other way.

the discovery

Last year, after a change of government, the new administration confirmed that Greece had indeed been cooking the books in its reports to the EU , to its citizens and to the outside world, in a major way for years.

With a lag of some months, these revelations have sparked the currency and bond crisis, akin to the Asian developing market worries of 1997, that we are in now.

positives?

We all know the negatives.  Are there any positives to be taken from the situation?  I think so.  Specifically,

1.  Better now than a year ago, when the whole world was falling apart.

2.  It appears that the EU is finally going to address the Greece issue instead of papering it over.  Germany, ever the economic policeman of Europe, seems unwilling to move down a slippery slope of denial and compromise. And even if it were, world government bond markets will no longer allow that to happen.  It’s unclear what the ultimate outcome for Greece will be—the two polar cases are its leaving the EU and and an IMF-led policy overhaul—but some thing definitive will happen.

3.  The Greece situation probably puts an end for a long while to the idea that the euro can replace the dollar as the world’s reserve currency, or even serve as a viable second team substitute.  This probably buys some time for the US to get its own fiscal house in order, but I think that’s a mixed blessing.

The implication for China, which is already offloading dollars through acquisitions and foreign aid as fast as it can, of the unsuitability of the euro as a home for its foreign currency reserves is to push harder to advance the renminbi as a medium for inernational trade.

3.  Germany vs. Greece can easily be seen as the pattern for the way a possible confrontation years down the road between China and the US might develop.   As such, it may serve as a salutary warning to the US.  I would particularly note that the Greek crisis came out of nowhere but quickly developed a savage intensity.  Scary.  And hopefully motivation to avoid the Greek outcome through sensible economic policy at any cost.

(On the other hand, given the strange (to me) way Washington operates, politicians could easily regard the real failing of Greece to be ruling out devaluation as an option by entering the EU.  This would imply that Congress and the sitting administration should set the inflationary ball rolling sooner rather than later.  Not good.  Also not a silver lining, and therefore a topic for another day.

Balance of Payments (II): internal and external structural adjustment

March 25, 2010 By in Balance of Payments, Basic Concepts, currency effects, economics Tags: , , , , , , , 1 Comment

The BoP accounts should balance

In the long term, the balance of payments accounts for a given country is supposed to balance, that is, net out to zero.

a simple example

This is a common sense notion.  It’s easiest to see if we take a simple, theoretical example.  Assume a world where there are only two countries, A and B, where all exports are priced in the local currency and all imports are priced in the foreign currency. (Everyone knows the first assumption isn’t true, but in the real world the second one isn’t, either.)

Further, call the currency of A the $ and the currency of B the @.  Let’s take the initial exchange rate as $1 = @1.

a trade/current account deficit…

Let’s take the case where country A produces $1 billion of goods that it exports to B, but still has an annual trade deficit of $100 million.  It gets @1 billion for the goods and services it exports to B but it still has to get another @100 million from B to pay for the extra $100 million of imports it purchases.

Where does this extra @100 million come from?  Not from today’s income-earning activities in country A.  Looking at the other balance of payments accounts, the other @100 million might come from dividend or interest payments from abroad.  If it doesn’t–and this is the most likely case–country A has to sell things to B to get the extra @100 million.  This “selling” can come either in the form of promises to pay, i.e. bank loans or corporate/government bonds, or in physical assets like commercial or residential real estate or manufacturing plant and equipment.

…isn’t sustainable forever

This situation can’t go on forever.  If nothing else, at some point country A will run out of assets that country B will desire to buy.   In our simple world, country B will then be piling up loads of $ that it doesn’t particularly want.  Initially, it will “recycle” extra $ into country A’s bonds to get some interest income.   But there’s a limit to that, as well.  Sooner or later, the debt will reach a level where country B will get worried about the possibility that A may not be able to repay.

The level of country B’s concern will depend to some degree on its analysis of the character of A’s economy and of its imports.  If country A is importing, for example, machinery it will use to develop new export-oriented or import-competing businesses, B will be less worried.  So, too, if it sees that some purely domestic industry has immense potential to develop into an exporter.  But if the imports are mostly of consumer items that will generate no future income–like TVs or building materials for McMansions–concern will rise a lot faster.

In any event,  a persistent trade (and current account) deficit will sooner or later cause downward pressure on country A’s currency.  Country B will demand a premium for continuing to hold $.  What happens then?

intervention

One possibility is that country A intervenes in the currency market to buy up the “extra” $ that are sloshing around.  That is, the government of A takes action to defend the $1 = @1 exchange rate.  It may also have help from country B in doing so, since the government of B may be satisfied with the status quo.  In the real world, this is not a good solution, since the big international commercial banks, who would be the most worried about the present situation and who may well be leading a trading attack on the $, have far greater market power than any set of governments.

Two possibilities remain–external structural adjustment or internal structural adjustment.

Internal adjustment means slowing down the purchase of imports, particularly of imported consumer goods.  In practical terms, this means the government raising interest rates and inducing a recession.  How so?  The problem country A faces is typically that government economic policy is too stimulative.  As a result, the country is living beyond its means.  Most of the “extra” economy energy is going into consumption, and a disproportionately large share of that is going into consumption of imported goods.

The practical issue with internal adjustment is that politicians find this very difficult to do, since the change in economic policy is very visible.  It’s also very clear to voters exactly who has taken away the punchbowl.

External adjustment means standing aside and letting the currency markets achieve a new equilibrium.  In other words, in our example, country A allows the $ to devalue to what is, for now anyway, a new equilibrium level.

This is the solution almost all countries opt for, even though it leaves internal structural problems unaddressed.  Why this path?  It’s easier politically.  Local citizens will likely not realize the large loss of national wealth that devaluation entails–unless they travel abroad.  And to the degree that citizens do notice that the local price of imported goods has increased, anger can easily be directed against “greedy” currency speculators or foreign industrialists.

In academic theory, adjustment through currency devaluation is an illusory process.  The economy reverts to its prior state of disequilibrium, only with inflation at a higher level.  For smaller countries, I think that this is true in reality as well.  In the case of large countries like the US, the reality is more complicated.  More about this in later posts.